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Use and Abuse of the “Natural Capital” Concept

by Herman Daly

Herman DalySome people object to the concept of “natural capital” because they say it reduces nature to the status of a commodity to be marketed at its exchange value. This indeed is a danger, well discussed by George Monbiot. Monbiot’s criticism rightly focuses on the monetary pricing of natural capital. But it is worth clarifying that the word “capital” in its original non-monetary sense means “a stock or fund that yields a flow of useful goods or services into the future.” The word “capital” derives from “capita” meaning “heads,” referring to heads of cattle in a herd. The herd is the capital stock; the sustainable annual increase in the herd is the flow of useful goods or “income” yielded by the capital stock–all in physical, not monetary, terms. The same physical definition of natural capital applies to a forest that gives a sustainable yield of cut timber, or a fish population that yields a sustainable catch. This use of the term “natural capital” is based on the relations of physical stocks and flows, and is independent of prices and monetary valuation. Its main use has been to call attention to and oppose the unsustainable drawdown of natural capital that is falsely counted as income.

Big problems certainly arise when we consider natural capital as expressible as a sum of money (financial capital), and then take money in the bank growing at the interest rate as the standard by which to judge whether the value of natural capital is growing fast enough, and then, following the rules of present value maximization, liquidate populations growing slower than the interest rate and replace them with faster growing ones. This is not how the ecosystem works. Money is fungible, natural stocks are not; money has no physical dimension, natural populations do. Exchanges of matter and energy among parts of the ecosystem have an objective ecological basis. They are not governed by prices based on subjective human preferences in the market.

Furthermore, money in the bank is a stock that yields a flow of new money (interest) all by itself without diminishing itself, and without the aid of other flows. Can a herd of cattle yield a flow of additional cattle all by itself, and without diminishing itself? Certainly not. The existing stock of cattle transforms a resource flow of grass and water into new cattle faster than old cattle die. And the grass requires sunlight, soil, air, and more water. Like cattle, capital transforms resource flows into products and wastes, obeying the laws of thermodynamics. Capital is not a magic substance that grows by creating something out of nothing.

While the environmentalist’s objections to monetary valuation of natural capital are sound and important, it is also true that physical stock-flow (capital-income) relations are important in both ecology and economics. Parallel concepts in economics and ecology aid the understanding and proper integration of the two realities–if their similarities are not pushed too far!

The biggest mistake in integrating economics and ecology is confusion about which is the Part and which is the Whole. Consider the following official statement, also cited by Monbiot:

As the White Paper rightly emphasized, the environment is part of the economy and needs to be properly integrated into it so that growth opportunities will not be missed.

—Dieter Helm, Chairman of the Natural Capital Committee, The State of Natural Capital: Restoring our Natural Assets, Second report to the Economic Affairs Committee, UK, 2014.

If the Chairman of the UK Natural Capital Committee gets it exactly backwards, then probably others do too. The environment, the finite ecosphere, is the Whole and the economic subsystem is a Part–a completely dependent part. It is the economy that needs to be properly integrated into the ecosphere so that its limits on the growth of the subsystem will not be missed. Given this fundamental misconception, it is not hard to understand how other errors follow, and how some economists, imagining that the ecosphere is part of the economy, get confused about valuation of natural capital.

Natural Capital, James Wheeler

How can we correctly price natural capital in a full world? Photo Credit: James Wheeler

In the empty world, natural capital was a free good, correctly priced at zero. In the full world, natural capital is scarce. How do we take account of that scarcity without prices? This question is what understandably leads economists to price natural capital, and then leads to the monetary valuation problems just discussed. But is there not another way to recognize scarcity, besides pricing? Yes, one could impose quotas–quantitative limits on the resource flows at ecologically sustainable levels that do not further deplete natural capital. We could recognize scarcity by living sustainably off of natural income rather than living unsustainably from the depletion of natural capital.

In economics, “income” is by definition the maximum amount that can be consumed this year without reducing the capacity to produce the same amount next year. In other words, income is by definition sustainable, and the whole reason for income accounting is to avoid impoverishment by inadvertent consumption of capital. This prudential rule, although a big improvement over present practice, is still anthropocentric in that it considers nature in terms only of its instrumental value to humans. Without denying the obvious instrumental value of nature to humans, many of us consider nature to also have intrinsic value, based partly on the enjoyment by other species of their own sentient lives. Even if the sentient experience of other species is quite reasonably considered less intrinsically valuable than that of humans, it is not zero. Therefore we have a reason to keep the scale of human takeover even below that indicated by maximization of instrumental value to humans. On the basis of intrinsic value alone, one may argue that the more humans the better–as long as we are not all alive at the same time! Maximizing cumulative lives ever to be lived with sufficient wealth for a good (not luxurious) life is very different from, and inconsistent with, maximizing simultaneous lives.

In addition, speaking for myself, and I expect many others, there is a deeper consideration. I cannot reasonably conceive (pace neo-Darwinist materialists) that our marvelous world is merely the random product of multiplying infinitesimal probabilities by infinitely many trials. That is like claiming that Hamlet was written by infinitely many monkeys, banging away at infinitely many typewriters. A world embodying mathematical order, a system of evolutionary adaptation, conscious rational thought capable of perceiving this order, and the moral ability to distinguish good from bad, would seem to be more like a creation than a happenstance. As creature-in-charge, whether by designation or default, we humans have the unfulfilled obligation to preserve and respect the capacity of Creation to support life in full. This is a value judgment, a duty based both historically and logically on a traditional theistic worldview. Although nowadays explicitly rejected by materialists, and by some theists who confuse dominion with vandalism, this worldview fortunately still survives as more than a vestigial cultural inheritance.

Whatever one thinks about these deeper issues, the point is that determination of the scale of resource throughput cannot reasonably be based on pseudo prices. But scale does have real consequences for prices. Fixing the scale of the human niche is a price-determining macro decision based on ethical and religious criteria. It is not a price-determined micro decision based on market expression of individual preferences weighted by ability to pay.

However the scale of the macro-limited resource flow is determined, we next face the question of how to ration that amount among competing micro claimants? By prices. So we are back to pricing, but in a very different sense. Prices now are tools for rationing a fixed predetermined flow of resources, and no longer determine the volume of resources taken from nature, nor the physical scale of the economic subsystem. Market prices (modified by taxes or cap-auction-trade) ration resources as an alternative to direct quantitative allocation by central planning. The physical scale of the economy has been limited, and the resulting scarcity rents are captured for the public treasury, permitting elimination of many regressive taxes. Dollars become ration tickets; no longer votes that determine how big the scale of the economy will be relative to the ecosystem. The market no longer conveys the message “we can grow as much as we want as long as we pay the price.” Rather the new message is, “there is only so much to go around, and dollars are your ration ticket for a part of the fixed quota, not a vote that can be cast for growth.” Equitable distribution of dollar incomes (ration tickets) will then be seen as the serious matter that it is, to be solved by sharing, not evaded by growth, especially not by uneconomic growth.

Unfortunately, the more common approach in economics has been to try somehow to calculate that price that internalizes sustainability and impose it via taxes. The right price, given the demand curve, will result in the corresponding right quantity. However, there is a two-fold problem: first, methods of calculating the “right” price are usually specious (e.g. contingent valuation); and second, we don’t really know where the shifting demand curve is, except on the blackboard. In fixing prices, errors in demand estimation result in variations in quantity. In fixing quantity, errors result in variations in price. The ecosystem is sensitive to quantity, not price. It is ecologically safer to let errors in estimation of demand result in price changes rather than quantity changes. This is one advantage of the cap-auction-trade system relative to carbon taxes. Although a great improvement over the present, carbon taxes attempt to ration carbon fuels without having really limited their supply. Nor are the “dollar ration tickets” limited, given the fractional reserve banks’ ability to create money, and the Fed’s policy of issuing more money whenever growth slows down.

A monetary reform to 100% reserve requirements on demand deposits would be a good policy for many reasons, to which we can add, as a necessary supplement to a carbon tax. It would not be necessary as a supplement to cap-auction-trade, but should be adopted for independent reasons. A good symbol should not be allowed to do things that the reality it symbolizes cannot do. One hundred percent reserves would require the symbol of money to behave more like real wealth, at least in some important ways. But this is another story.

Three More Growth Fallacies

by Herman Daly

Herman DalyIn a previous essay I identified eight fallacies about growth. Well, at the risk of starting a growth industry, here are three more.

1. As natural resources become scarce we can substitute capital for resources and continue to grow. Growth economists assume a high degree of substitutability between factors of production. But if one considers a realistic analytic description of production, as given in Georgescu-Roegen’s fund-flow model, one sees that factors are of two qualitatively different kinds: (1) resource flows that are physically transformed into flows of product and waste and (2) capital and labor funds, the agents or instruments of transformation that are not themselves physically embodied in the product. There are varying degrees of substitution between different resource flows, and between the funds of labor and capital. But the basic relation between resource flow on the one hand, and a capital (or labor) fund on the other, is complementarity. You cannot bake a hundred-pound cake with only one pound of ingredients, no matter how many cooks and ovens you have. Efficient cause (capital) does not substitute for material cause (resources). Material cause and efficient cause are related as complements, and the one in short supply is limiting. Complementarity makes possible the existence of a limiting factor, which cannot exist under substitutability. In yesterday’s empty world the limiting factor was capital; in today’s full world remaining natural resources have become limiting.

This fundamental change in the pattern of scarcity has not been incorporated into the thinking of growth economists. Nor have they paid sufficient attention to the fact that capital is itself made from and maintained by natural resource flows. It is hard for a factor to substitute for that from which it is made! And consider yet another oversight. Substitution is reversible — if capital is a good substitute for resources, then resources are a good substitute for capital. But then why, historically, would we ever have accumulated capital in the first place if nature had already given us a good substitute? In sum, the claim that capital is a good substitute for natural resources is absurd.

In reply to these criticisms, growth economists point to modern agriculture, which they consider the prime example of substitution of capital for resources. But modern, mechanized agriculture has simply substituted one set of resource flows for another, and one set of funds for another. It has partially replaced soil, sunlight, rainfall, and manure, with other resources, namely fossil fuels, chemical fertilizers, pesticides, and water pumped from rivers and aquifers. The old resource flows (soil, sunlight, rain, manure) were to a significant degree replaced by new resource flows (fossil fuels, chemicals, irrigation water), not by capital! The old fund factors of labor, draft animals, and hand tools were replaced by new fund factors of tractors, harvesters, etc. In other words new fund factors substituted for old fund factors, and new resource flows substituted for old resource flows. Modern agriculture involves the substitution of capital for labor (both funds), and the substitution of nonrenewable resources for renewable resources (both flows). In energy terms it was largely the substitution of fossil fuels for solar energy, a move with short-term benefits and long-term costs. But there was no substitution of capital funds for resource flows. The case of mechanization of agriculture does not contradict the complementarity of fund and flow factors in production.

2. Space, the high frontier, frees us from the finitude of the earth, and opens unlimited resources for growth. In a secular age where many have lost faith in the spiritual dimension of existence, and where the concept of “man as creature” is eclipsed by that of “man as creator,” it is to be expected that science fiction might be called on to fill the dead void of space with a happy population of “survivors.” The spiritual insights of millennia are replaced by technocratic projections of the “Singularity” in which mankind attains the final goal of (random?) evolution and becomes a new and immortal species, thanks to the salvific power of exponential growth in information processing technology. Moore’s Law promises eternal silicon-based life for the new elect who can stay alive until the Singularity; oblivion for those who die too soon! And this comes from materialists who think that they have outgrown religion!

Space tourism: a silly reason to believe in infinite economic growth.

Of course many technical space accomplishments are real and impressive. But how do they free us from the finitude of the earth and open up unlimited resources for growth? Space accomplishments have been extremely expensive in terms of terrestrial resources, and have yielded few extra-terrestrial resources — useless moon rocks that some fledgling astronaut managed to steal from NASA in a bungled attempt to sell them for their collector’s value, plus some space tourism for a few billionaires to take orbital joyrides. On the positive side of the ledger we can list communications satellites, but they are oriented to earth, and while they can help us use earth’s resources more efficiently, they do not bring in new resources. And apparently some orbits are getting crowded with satellite carcasses.

Robotic space exploration is a lot cheaper than manned space missions, and may (or may not) yield knowledge worth the investment to a society that cannot afford basic necessities and elementary education for many. The opportunity cost of indulging the expensive curiosity of a few is to leave undeveloped the capacities of many. Were it not for the heavy military connection (muted in the official NASA propaganda) we would probably be spending much less on space. Cuts in NASA’s budget have led to the over-hyped reaction by the “space community” in proclaiming a pseudo-religious technical quest to discover “whether or not we are alone in the universe,” as opposed to how to zap other earthlings with laser beams from space. Another major goal is to find a planet suitable for colonization by earthlings. The latter is sometimes justified by the observation that since we are clearly destroying the earth we need a new home — to also destroy?

The numbers — astronomical distances and time scales — effectively rule out dreams of space colonization. But another consideration is equally daunting. If we are unable to control population and production growth on earth, which is our forgiving and natural home, out of which we were created and with which we have evolved and adapted, then what makes us think we can live as aliens within the much tighter and unforgiving discipline of a space colony on a dead rock in a cold vacuum? There we would encounter limits to growth raised to the hundredth power. Sorry for being such a “pessimist!”

3. Without economic growth all progress is at an end. On the contrary, without growth (now actually uneconomic growth if correctly measured), true progress finally will have a chance. As ecological economists have long argued, growth is quantitative physical increase in the matter-energy throughput, the metabolic maintenance flow of the economy beginning with depletion and ending with pollution. Development, in contrast, is qualitative improvement in the capacity of a given throughput to provide for the maintenance and enjoyment of life in community. The main ways to develop are through technical improvement in resource efficiency, and ethical improvement in our wants and priotities.

Development without growth beyond the earth’s carrying capacity is true progress. Growth means larger jaws and a bigger digestive tract for more rapidly converting more resources into more waste, in the service of unexamined and frequently destructive individual wants. Development means better digestion of a non-growing throughput, and more worthy and satisfying goals to which our life energies could be devoted.

What Is the Limiting Factor?

by Herman Daly

Herman DalyIn yesteryear’s empty world capital was the limiting factor in economic growth. But we now live in a full world.

Consider: What limits the annual fish catch — fishing boats (capital) or remaining fish in the sea (natural resources)? Clearly the latter. What limits barrels of crude oil extracted — drilling rigs and pumps (capital), or remaining accessible deposits of petroleum — or capacity of the atmosphere to absorb the CO2 from burning petroleum (both natural resources)? What limits production of cut timber — number of chain saws and lumber mills, or standing forests and their rate of growth? What limits irrigated agriculture — pumps and sprinklers, or aquifer recharge rates and river flow volumes? That should be enough to at least suggest that we live in a natural resource-constrained world, not a capital-constrained world.

Economic logic says to invest in and economize on the limiting factor. Economic logic has not changed; what has changed is the limiting factor. It is now natural resources, not capital, that we must economize on and invest in. Economists have not recognized this fundamental shift in the pattern of scarcity. Nobel Laureate in chemistry and underground economist, Frederick Soddy, predicted the shift eighty years ago. He argued that mankind ultimately lives on current sunshine, captured with the aid of plants, soil, and water. This fundamental permanent basis for life is temporarily supplemented by the release of trapped sunshine of Paleozoic summers that is being rapidly depleted to fuel what he called “the flamboyant age.” So addicted are we to this short-run subsidy that our technocrats advocate shutting out some of the incoming solar energy to make more thermal room for burning fossil fuels! These educated cretins are also busy chemically degrading the topsoil and polluting the water, while tinkering with the genetic basis of plants, all toward the purpose of maximizing short-run growth. As Wes Jackson says, agricultural plants now have genes selected by the Chicago Board of Trade, not by fitness to the ecosystem of surrounding organisms and geography.

What has kept economists from recognizing Soddy’s insight? An animus against dependence on nature, and a devotion to dominance. This basic attitude has been served by a theoretical commitment to factor substitutability and a neglect of complementarity by today’s neoclassical economists. In the absence of complementarity there can be no limiting factor — if capital and natural resources are substitutes in production then neither can be limiting — if one is in short supply you just substitute the other and continue producing. If they are complements both are necessary and the one in short supply is limiting.

Economists used to believe that capital was the limiting factor. Therefore they implicitly must have believed in complementarity between capital and natural resources back in the empty-world economy. But when resources became limiting in the new full-world economy, rather than recognizing the shift in the pattern of scarcity and the new limiting factor, they abandoned the whole idea of limiting factor by emphasizing substitutability to the exclusion of complementarity. The new reason for emphasizing capital over natural resources is the claim that capital is a near perfect substitute for resources.

William Nordhaus and James Tobin were quite explicit (“Is Growth Obsolete?,” 1972, NBER, Economic Growth, New York: Columbia University Press):

The prevailing standard model of growth assumes that there are no limits on the feasibility of expanding the supplies of nonhuman agents of production. It is basically a two-factor model in which production depends only on labor and reproducible capital. Land and resources, the third member of the classical triad, have generally been dropped… the tacit justification has been that reproducible capital is a near perfect substitute for land and other exhaustible resources.

The claim that capital is a near perfect substitute for natural resources is absurd. For one thing substitution is reversible. If capital is a near perfect substitute for resources, then resources are a near perfect substitute for capital — so why then did we ever bother to accumulate capital in the first place if nature already endowed us with a near perfect substitute?

It is not for nothing that our system is called “capitalism” rather than “natural resource-ism.” It is ideologically inconvenient for capitalism if capital is no longer the limiting factor. But that inconvenience has been met by claiming that capital is a good substitute for natural resources. Ever true to its basic animus of denying any fundamental dependence on nature, neoclassical economics saw only two alternatives — either nature is not scarce and capital is limiting, or nature’s scarcity doesn’t matter because manmade capital is a near perfect substitute for natural resources. In either case man is in control of nature, thanks to capital, and that is the main thing. Never mind that manmade capital is itself made from natural resources.

The absurdity of the claim that capital and natural resources are good substitutes has been further demonstrated by Georgescu-Roegen in his fund-flow theory of production. It recognizes that factors of production are of two qualitatively different kinds: (1) resource flows that are physically transformed into flows of product and waste; and (2) capital and labor funds, the agents or instruments of transformation that are not themselves physically embodied in the product. If one finds a machine screw or a piece of a worker’s finger in one’s can of soup, that is reason for a lawsuit, not confirmation of the metaphysical notion that capital and labor are somehow “embodied” in the product!

There are varying degrees of substitution between different natural resource flows, and between the funds of labor and capital. But the basic relation between resource flow on the one hand, and capital (or labor) fund on the other, is complementarity. Efficient cause (capital) does not substitute for material cause (resources). You can’t bake the same cake with half the ingredients no matter if you double or triple the number of cooks and ovens. Funds and flows are complements.

Further, capital is current surplus production exchanged for a lien against future production — physically it is made from natural resources. It is not easy to substitute away from natural resources when the presumed substitute is itself made from natural resources.

It is now generally recognized, even by economists, that there is far too much debt worldwide, both public and private. The reason so much debt was incurred is that we have had absurdly unrealistic expectations about the efficacy of capital to produce the real growth needed to redeem the debt that is “capital” by another name. In other words the debt that piled up in failed attempts to make wealth grow as fast as debt is evidence of the reality of limits to growth. But instead of being seen as such, it is taken as the main reason to attempt still more growth by issuing more debt, and by shifting bad debts from the balance sheet of private banks to that of the public treasury, in effect monetizing them.

The wishful thought leading to such unfounded growth expectations was the belief that by growth we would cure poverty without the need to share. As the poor got richer, the rich could get still richer! Few expected that aggregate growth itself would become uneconomic, would begin to cost us more than it was worth at the margin, making us collectively poorer, not richer. But it did. In spite of that, our economists, bankers, and politicians still have unrealistic expectations about growth. Like the losing gambler they try to get even by betting double or nothing on more growth.

Could we not take a short time-out from growth roulette to reconsider the steady-state economy? After all, the idea is deeply rooted in classical economics, as well as in physics and biology. Perpetual motion and infinite growth are not reasonable premises on which to base economic policy.

At some level many people surely know this. Why then do we keep growth as the top national priority? First, we are misled because our measure of growth, GDP, counts all “economic activity” thereby conflating costs and benefits, rather than comparing them at the margin. Second, the cumulative net benefit of past growth is a maximum at precisely the point where further growth becomes uneconomic (where declining marginal benefit equals increasing marginal cost), and past experience ceases to be a good guide to the future in this respect. Third, because even though the benefits of further growth are now less than the costs, our decision-making elites have figured out how to keep the dwindling extra benefits for themselves, while “sharing” the exploding extra costs with the poor, the future, and other species. The elite-owned media, the corporate-funded think tanks, the kept economists of high academia, and the World Bank — not to mention Gold Sacks and Wall Street — all sing hymns to growth in perfect unison, and bamboozle average citizens.

What is going to happen?

Capital, Debt, and Alchemy

by Herman Daly

Herman Daly“Capital,” said Nobel chemist and pioneer ecological economist Frederick Soddy,”merely means unearned income divided by the rate of interest and multiplied by 100.” (Cartesian Economics, p. 27).

He further explained that, “Although it may comfort the lender to think that his wealth still exists somewhere in the form of “capital,” it has been or is being used up by the borrower either in consumption or investment, and no more than food or fuel can it be used again later. Rather it has become debt, an indent on future revenues…”

In other words capital in the financial sense is the perennial net revenue stream expected from the project financed, divided by the assumed rate of interest and multiplied by 100. Rather than magic growth-producing real stuff, it is a hypothetical calculation of the present value of a permanent lien on the future real production of the economy. The fact that the lien can be traded among individuals for real wealth in the present does not change the fact that it is still a lien against the future revenue of society — in a word it is a debt that the future must pay, no matter who owns it or how often it is traded as an asset in the present.

Soddy believed that the ruling passion of our age is to convert wealth into debt in order to derive a permanent future income from it — to convert wealth that perishes into debt that endures, debt that does not rot or rust, costs nothing to maintain, and brings in perennial “unearned income,” as both IRS accountants and Marxists accurately call it. No individual could amass the physical requirements sufficient for maintenance during old age, for like manna it would spoil if accumulated much beyond current need. Therefore one must convert one’s non-storable current surplus into a lien on future revenue by letting others consume and invest one’s surplus now in exchange for the right to share in the expected future revenue. But future real physical revenue simply cannot grow as fast as symbolic monetary debt! In Soddy’s words:

You cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest], against the natural law of the spontaneous decrement of wealth [entropy]. (Cartesian Economics, p. 30).

In case that is a too abstract statement of a too general principle, Soddy gave a simple example. Minus two pigs (debt) is a mathematical quantity having no physical existence, and the population of negative pigs can grow without limit. Plus two pigs (wealth) is a physical quantity, and their population growth is limited by the need to feed the pigs, dispose of their waste, find space for them, etc. Both may grow at a given x% for a while, but before long the population of negative pigs will greatly outnumber that of the positive pigs, because the population of positive pigs is limited by the physical constraints of a finite and entropic world. The value of a negative pig will fall to a small fraction of the value of a positive pig. Owners of negative pigs will be greatly disappointed and angered when they try to exchange them for positive pigs. In today’s terms, instead of negative pigs, think “unfunded pension liabilities” or “sub-prime mortgages.”

Soddy went on to speculate about how historically we came to confuse wealth with debt:

Because formerly ownership of land — which, with the sunshine that falls on it, provides a revenue of wealth — secured, in the form of rent, a share in the annual harvest without labor or service, upon which a cultured and leisured class could permanently establish itself, the age seems to have conceived the preposterous notion that money, which can buy land, must therefore itself have the same revenue-producing power.

The ancient alchemists wanted to transmute corrosion-prone base metals into permanent, non-corruptible, time-resistant gold. Modern economic alchemists want to convert spoiling, rusting, and depleting wealth into a magic substance better than gold — not only does it resist corrosion, but it grows — by some mysterious principle the alchemists referred to as the “vegetative property of metals.” The modern alchemical philosopher’s stone, known as “capital” or “debt,” is not only free from the ravages of time and entropy, but embodies the alchemists’ long-sought-for principle of vegetative growth of metals. But once we replace alchemy with chemistry we find that the idea that future people can live off the interest of their mutual indebtedness is just another perpetual motion delusion.

The exponentially growing indent of debt on future real revenue will, in a finite and entropic world, become greater than future producers are either willing or able to transfer to owners of the debt. Debt will be repudiated either by inflation, bankruptcy, or confiscation, likely leading to serious violence. This prospect of violence especially bothered Soddy because, as the discoverer of the existence of isotopes, he had contributed substantially to the theory of atomic structure that made atomic energy feasible. He predicted in 1926 that the first fruit of this discovery would be a bomb of unprecedented power. He lived to see his prediction come true. Removing the economic causes of conflict therefore became for him a kind of redeeming priority.

Economists have ignored Soddy for eighty years — after all, he only got the Nobel Prize in Chemistry, not the more alchemical “Swedish Riksbank Memorial Prize for Economics in Honor of Alfred Nobel.”

Wealth, Illth, and Net Welfare

by Herman Daly

Adapted from an article published in Resurgence.

Herman DalyWellbeing should be counted in net terms — that is to say we should consider not only the accumulated stock of wealth but also that of “illth;” and not only the annual flow of goods but also that of “bads.” The fact that we have to stretch English usage to find words like illth and bads with which to name the negative consequences of production that should be subtracted from the positive consequences, is indicative of our having ignored the realities for which these words are the necessary names. Bads and illth consist of things like nuclear wastes, the dead zone in the Gulf of Mexico, biodiversity loss, climate change from excess carbon in the atmosphere, depleted mines, eroded topsoil, dry wells, exhausting and dangerous labor, congestion, etc. We are indebted to John Ruskin for the word “illth,” and to an anonymous economist, perhaps Kenneth Boulding, for the word “bads.” In the empty world of the past these concepts and the names for them were not needed because the economy was so small relative to the containing natural world that our production did not incur any significant opportunity cost of displaced nature. We now live in a full world, full of us and our stuff, and such costs must be counted and netted out against the benefits of growth. Otherwise we might end up with extra bads outweighing extra goods, and increases in illth greater than the increases in wealth. What used to be economic growth could become uneconomic growth — that is, growth in production for which marginal costs are greater than marginal benefits, growth that in reality makes us poorer, not richer. No one is against being richer. The question is, does growth any longer really make us richer, or has it started to make us poorer?

I suspect it is now making us poorer, at least in some high-GDP countries, and we have not recognized it. Indeed, how could we when our national accounting measures only “economic activity.” Activity is not separated into costs and benefits. Everything is added in GDP, nothing subtracted. The reason that bads and illth, inevitable joint products with goods and wealth, are not counted, even when no longer negligible in the full world, is that obviously no one wants to buy them, so there is no market for them, and hence no price by which to value them. But it is worse — these bads are real and people are very willing to buy the anti-bads that protect them from the bads. For example, pollution is an unpriced, uncounted bad, but pollution clean-up is an anti-bad which is accounted as a good. Pollution cleanup has a price and we willingly pay it up to a point and add it to GDP — but without having subtracted the negative value of the pollution itself that made the clean up necessary. Such asymmetric accounting hides more than it reveals.

In addition to asymmetric accounting of anti-bads, we count natural capital depletion as if it were income, further misleading ourselves. If we cut down all the trees this year, catch all the fish, burn all the oil and coal, etc., then GDP counts all that as this year’s income. But true income is defined as the maximum that a community can consume this year, and still produce and consume the same amount next year — maximum production while maintaining intact future capacity to produce (capital in the broadest sense). Nor is it only depletion of natural capital that is falsely counted as income — failure to maintain and replace depreciation of man-made capital, such as roads and bridges, has the same effect. Much of what we count in GDP is capital consumption and anti-bads.

As argued above, one reason that growth may be uneconomic is that we discover that its neglected costs are greater than we thought. Another reason is that we discover that the extra benefits of growth are less than we thought. This second reason has been emphasized in the studies of self-evaluated happiness, which show that beyond a threshold annual income of some $20-25 thousand, further growth does not increase happiness. Happiness, beyond this threshold, is overwhelmingly a function of the quality of our relationships in community by which our very identity is constituted, rather than the quantity of goods consumed. A relative increase in one’s income still yields extra individual happiness, but aggregate growth is powerless to increase everyone’s relative income. Growth in pursuit of relative income is like an arms race in which one party’s advance cancels that of the other. It is like everyone standing and craning his neck in a football stadium while having no better view than if everyone had remained comfortably seated.

Check out the wellbeing issue of Resurgence Magazine.

As aggregate growth beyond sufficiency loses its power to increase welfare, it increases its power to produce illth. This is because to maintain the same rate of growth ever more matter and energy has to be mined and processed through the economy, resulting in more depletion, more waste, and requiring the use of ever more powerful and violent technologies to mine the ever leaner and less accessible deposits. Petroleum from an easily accessible well in East Texas costs less labor and capital to extract, and therefore directly adds less to GDP, than petroleum from an inaccessible well a mile under the Gulf of Mexico. The extra labor and capital spent to extract a barrel in the Gulf of Mexico is not a good or an addition to wealth — it is more like an anti-bad made necessary by the bad of depletion, the loss of a natural subsidy to the economy. In a full employment economy the extra labor and capital going to petroleum extraction would be taken from other sectors, so aggregate real GDP would likely fall. But the petroleum sector would increase its contribution to GDP as nature’s subsidy to it diminished. We would be tempted to regard it as more rather than less productive.

The next time some economist or politician tells you we must do everything we can to grow (in order to fight poverty, win wars, colonize space, cure cancer, whatever…), remind him that when something grows it gets bigger! Ask him how big he thinks the economy is now, relative to the ecosphere, and how big he thinks it should be. And what makes him think that growth is still causing wealth to increase faster than illth? How does he know that we have not already entered the era of uneconomic growth? And if we have, then is not the solution to poverty to be found in sharing now, rather than in the empty promise of growth in the future? If you get a reasoned, coherent answer, please send it to me!

Growth, Debt, and the World Bank

by Herman Daly

Herman DalyWhen I was in graduate school in economics in the early 1960s we were taught that capital was the limiting factor in growth and development. Just inject capital into the economy and it would grow. As the economy grew, you could then re-invest the growth increment as new capital and make it grow exponentially. Eventually the economy would be rich. Originally, to get things started, capital came from savings, from confiscation, or from foreign aid or investment, but later out of the national growth increment itself. Capital embodied technology, the source of its power. Capital was magic stuff, but scarce. It all seemed convincing at the time.

Many years later when I worked for the World Bank it was evident that capital was no longer the limiting factor, if indeed it ever had been. Trillions of dollars of capital was circling the globe looking for projects in which to become invested so it could grow. The World Bank understood that the limiting factor was what they called “bankable projects” — concrete investments that could embody abstract financial capital and make its value grow at an acceptable rate, usually ten percent per annum or more, doubling every seven years. Since there were not enough bankable projects to absorb the available financial capital the WB decided to stimulate the creation of such projects with “country development teams” set up in the borrowing countries, but with WB technical assistance. No doubt many such projects were useful, but it was still hard to grow at ten percent without involuntarily displacing people, or running down natural capital and counting it as income, both of which were done on a grand scale. And the loans had to be repaid. Of course they did get repaid, frequently not out of the earnings of the projects which were often disappointing, but out of the general tax revenues of the borrowing governments. Lending to sovereign governments with the ability to tax greatly increases the likelihood of being repaid — and perhaps encourages a bit of laxity in approving projects.

Where did all this excess financial capital come from? Not from savings (China excepted), but from new money and easy credit generated by our fractional reserve banking system, amplified by increased leverage in the purchase of stocks. Recipients of new money bid resources away from existing uses by offering a higher price. If there are unemployed resources and if the new uses are profitable then the temporary rise in prices is offset by new production — by growth. But resource and environmental scarcity, along with a shortage of bankable projects, put the brakes on this growth, and resulted in too much financial capital trying to become incarnate in too few bankable projects.

So the WB had to figure out why its projects yielded low returns. The answer sketched above was ideologically unacceptable because it hinted at ecological limits to growth. A more acceptable answer soon became clear to WB economists — micro level projects could not be productive in a macro environment of irrational and inefficient government policy. The solution was to restructure the macro economies by “structural adjustment” — free trade, export-led growth, balanced budgets, strict control of inflation, elimination of social subsidies, deregulation, suspension of labor and environmental protection laws — the so-called Washington Consensus. How to convince borrowing countries to make these painful “structural adjustments” at the macro level to create the environment in which WB financed projects would be productive? The answer was, conveniently, a new form of lending, structural adjustment loans, to encourage or bribe the policy reforms stipulated by the term “structural adjustment.” An added reason for structural adjustment, or “policy lending,” was to move lots of dollars quickly to countries like Mexico to ease their balance of payments difficulty in repaying loans they had received from private US banks. Also, policy loans, now about half of WB lending, require no lengthy and expensive project planning and supervision the way project loans do. The money moves quickly. The WB definition of efficiency became, it seemed, “moving the maximum amount of money with the minimum amount of thought.”

Why, one might ask, would a country borrow money at interest to make policy changes that it could make on its own without any loans, if it thought the policies were good ones? Maybe they did not really favor the policies, and therefore needed a bribe to do what was in their own best interests. Maybe the goal of the current borrowing government was simply to get the new loan, splash the money around among friends and relatives, and leave the next government to pay it back with interest.

Such thoughts got little attention at the WB which was haunted by the specter of an impending “negative payments flow,” that is, repayments of old loans plus interest greater than the volume of new loans. Would the WB eventually shrink and disappear as unnecessary? A horrible thought for any bureaucracy! But the alternative to a negative payments flow for the WB is ever-increasing debt for the borrowing countries. Of course the WB did not claim to be in the business of increasing the debt of poor countries. Rather it was fostering growth by injecting capital and increasing the debtor countries’ capacity to absorb capital from outside. So what if the debt grew, as long as GDP was growing. The assumption was that the real sector could grow as fast as the financial sector — that physical wealth could grow as fast as monetary debt.

The main goal of the WB is to make loans, to push the money out the door, to be a money pump. If financial capital were really the limiting factor countries would line up with good projects and the WB would ration capital among countries. But financial capital is superabundant and good projects are scarce, so the WB had to actively push the money. To speed up the pump they send country development teams out to invent projects; if the projects fail, then they invent structural adjustment loans to induce a more favorable macro environment; if structural adjustment loans are treated as bribes by corrupt borrowing governments, the WB does not complain too much for fear of slowing the money pump and incurring a “negative payments flow.”

If capital is no longer the magic limiting factor whose presence unleashes economic growth, then what is it?

“Capital,” says Frederick Soddy,”merely means unearned income divided by the rate of interest and multiplied by 100” (Cartesian Economics, p. 27). He further explains that, “Although it may comfort the lender to think that his wealth still exists somewhere in the form of “capital,” it has been or is being used up by the borrower either in consumption or investment, and no more than food or fuel can it be used again later. Rather it has become debt, an indent on future revenues…”

In other words capital in the financial sense is the future expected net revenue from a project divided by the rate of interest and multiplied by 100. Rather than magic stuff it is an indent, a lien, on the future real production of the economy — in a word it is a debt to be repaid, or alternatively, and perhaps preferably, to not be repaid but kept as the source of interest payments far into the future.

Of course debt is incurred in exchange for real resources to be used now, which as Soddy says cannot be used again in the future. But if the financed project can extract more resources employing more labor in the future to increase the total revenue of society, then the debt can be paid off with interest, and with some of the extra revenue left over as profit. But this requires an increased throughput of matter and energy, and increased labor — in other words it requires physical growth of the economy. Such growth in yesterday’s empty-world economy was reasonable — in today’s full-world economy it is not. It is now generally recognized that there is too much debt worldwide, both public and private. The reason so much debt was incurred is that we have had absurdly unrealistic expectations about growth. We never expected that growth itself would begin to cost us more than it was worth, making us poorer, not richer. But it did. And the only solution our economists, bankers, and politicians have come up with is more of the same! Could we not at least take a short time-out to discuss the idea of a steady-state economy?

Not Production, Not Consumption, but Transformation

by Herman Daly

Herman DalyWell-established words can be misleading. In economics “production and consumption” are such common terms that it is easy to forget that they do not really mean what they literally say. Physically we do not produce anything; we just use energy to rearrange matter into a more useful form. Production really means transformation of what is already here. Likewise, consumption merely reflects the disarrangement of carefully structured materials by the wear and tear of use into a less useful form — another transformation, this time from useful product into worn out product and waste. Of course one might say that we are producing and consuming “value” or “utility”, not really physical things. However, value is always added to something physical, namely resources, by labor and capital, which are also physical things ultimately made from the same low-entropy energy and materials that go into products. Nor does the service sector escape physical dimensions — services are always rendered by something or somebody. To abstract from physical dimensions and focus only on utility is to throw out the baby and pour bathwater on the diaper.

If we were to speak of a “transformation function” rather than a production function then we would naturally have to specify what is being transformed, into what, by the agency of what? Natural resource flows are transformed into flows of goods (and wastes), by the fund agents of labor and capital. A transformation function must show both the agents of transformation (funds of labor and capital that are not themselves transformed into the product but are needed to effect the transformation), and the flow of resources that are indeed physically embodied in the flow of products, or waste. This distinction between fund and flow factors immediately reveals their complementary roles as efficient cause and material cause — any substitution between them is very limited. You cannot bake the same cake with half the flour, eggs, etc. by doubling the number of cooks and the size of the oven. One natural resource can often substitute for another, and capital can often substitute for labor or vice versa, but more labor and capital can hardly substitute for a smaller resource flow, beyond the very limited extent of sweeping up and re-using process waste such as scraps, sawdust, etc. which ought to have already been accounted for in specifying a technically efficient production function. In most textbooks the production function depicts output as a function of inputs, undifferentiated as to their fund or flow nature, and all considered fundamentally substitutable.

But if the usual production function does not distinguish fund agents of transformation from the flow of natural resources being transformed, then how does it envisage the process of converting factor inputs into product outputs? Usually by multiplying them together, as in the Cobb-Douglas and other multiplicative functions. What could be more natural linguistically than multiplying “factors” to get a “product”? But this is mathematics, not economics. There is absolutely nothing analogous to multiplication going on in what we customarily call production — there is only transformation. Try to multiply the resource flow by labor or capital to get product outflow and your “production function” will have immediately run afoul of the law of conservation of mass. Perhaps to escape such incongruities most production functions contain only labor and capital, omitting resources entirely. We can now bake our cake with only the cook and her oven, no ingredients to be transformed at all! You can multiply cooks times ovens all you want and you still won’t get a meal.

How did this nonsense come into economics? I suspect it represents a confusion between the production function as a theoretical analytical description of the physical process of transformation (a recipe), and production function as a mere statistical correlation between outputs and inputs. The latter is common in macroeconomics, the former in microeconomics, although that is not a hard and fast rule because the distinction between a theoretical description and a statistical correlation is often ignored in both areas. The statistical approach usually includes only labor and capital as factor inputs, and then discovers that these two factors “explain” only 60% of the historical change in output, leaving a 40% residual to be explained by “something else”. No problem, say the growth economists, that large residual is “obviously” a measure of technological progress. However, the statistical residual is in fact a measure of everything that is not capital and labor — including specifically the quantity and quality of resources transformed. Increased resource use gets counted in the residual and attributed to technological progress. Then that same measure of technical progress is appealed to in order to demonstrate the unimportance of resources! If we thought in terms of a transformation function, rather than production ex nihilo it would be hard to make such an error.

The basic points just made were developed more rigorously forty years ago by Nicholas Georgescu-Roegen in his fund-flow critique of the neoclassical production function. Neoclassical growth economists have never answered his critique. Why bring it up again, and what is the relevance to steady-state economics? It is worth raising the issue again precisely because it has never been answered. What kind of a science is it that can get away with ignoring a fundamental critique for forty years? It is relevant to steady-state economics because it views production as physical transformation subject to biophysical limits and the laws of thermodynamics. Also it shows that the force of resource scarcity is in the nature of a limiting factor, and not so easy to escape by substitution of capital for resources, as often claimed by neoclassical growth economists.